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Value Investing in Brazil in 2016

Brazil is going through a rough patch. After successfully hosting (but losing) the World Cup in 2014, the country ended the year by reelecting President Dilma Rousseff of the Workers' Party for a second term. Political dramas began to emerge from Brasília and Curitiba relating to Operation Car Wash, an investigation by the federal police into a massive public corruption scandal involving Brazilian captains of industry and senior politicians of the parties forming the ruling coalition.

In the two years since Operation Car Wash went public, the real, Brazil's currency, has lost approximately 40% of its value, Brazil's sovereign credit rating has been cut to junk, unemployment has increased, the capital markets have frozen, GDP decreased by 3.8% in 2015 and continues to decline, and the national mood has dampened. Major financial institutions have pulled back: HSBC has sold its Brazilian operations to Banco Bradesco, and Citibank is planning on selling its Brazilian retail banking business. Moreover, Brazil's Congress has voted to impeach and suspend President Rousseff, who will be tried by the Senate, and Eduardo Cunha, formerly the speaker of the lower house of Brazil's Congress, has resigned from that post amid an investigation of alleged corruption (after having been suspended from that post in May by the Supreme Court).

The state of the global economy further compounds these troubles: the relatively low prices of commodities hurt Brazilian businesses that have been relying on the export of such commodities. China's slowdown and decreased appetite for commodities only adds to the problem.

We conducted an informal survey of colleagues investing in or doing business in Brazil, asking for their comments and feedback on the present state of investing there. Our sources, while lamenting Brazil's short-term troubles, maintain that Brazil's fundamentals are strong, and the country boasts a young population of over 200 million people who are increasingly well educated and more active on social media than consumers in other nations. These factors provide the basis for such commentators to advance the thesis that Brazil will come around, even if it takes several years, and that the current environment with a cheap Brazilian real and attractive valuations presents an ideal opportunity for value investors to seek opportunities in Brazil. While these commentators provide strong arguments to advance this thesis, we queried our sources for any examples of successful investments having been executed.

Yes, says Ettore V. Biagioni, the managing partner of the Alothon Group, a private equity firm. Having made one such investment in October of last year that fits this investment thesis, Alothon is actively taking advantage of opportunities in the present market, though Mr. Biagioni says that he has not seen as much recent activity in Brazil among private equity firms as he had expected. To justify Alothon's optimism about the fundamentals of the Brazilian economy, he points to the 40 million Brazilians who have moved out of poverty since the beginning of the century, positing that this progress will not be materially affected by the present recession. The economic measures being implemented by the new Temer regime will cause some pain, but are necessary to fix past mistakes and provide a solid foundation for the future of the country. Mr. Biagioni thinks that the country's currency reserves and strong fundamentals will allow it to recover in the medium term. Companies with strong management and a solid capital structure will outperform their competitors in this challenging environment.

Thiago Jabor Pinheiro, a partner at Mattos Filho, Veiga Filho, Marrey Jr. e Quiroga Advogados in São Paulo, says that his firm has recently seen increased interest by foreign investors in such value acquisitions, and that investors are particularly concerned with anti-corruption policies and practices when performing due diligence on potential targets. Mr. Pinheiro describes this increased interest as a cautious sort; investors are following through to actually make investments only when all factors coalesce in the form of a good deal.

Eduardo Zilberberg, a partner at Dias Carneiro Advogados in São Paulo, has also noted an uptick in distressed acquisitions and restructurings. He points out that some sectors, such as oil & gas, sugar & ethanol, and construction, are particularly ripe as targets, but cautions, nonetheless, that the level of activity is not commensurate with what one would expect in a healthy, growing economy. Mr. Zilberberg points to two factors affecting this activity: (i) the low price of the Brazilian real, which affects international investors by making potential investments cheaper, and (ii) the recession, which has forced some companies to sell assets on the cheap or to combine or engage in some other strategic transactions to survive. And while Mr. Zilberberg has observed an increased interest among private equity investors in buying Brazilian companies, he thinks that some reluctance to execute these deals may stem from the lingering question – have we hit bottom?

While Brazilian companies may not be getting gobbled up by investors looking for good deals, the value investor thesis remains viable, and continues to pique the interest of those with faith in the fundamentals of the Brazilian economy and an appetite for risk.

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